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STRATEGIES; Explaining Away the Dividend Yield

ONE of the great unsolved mysteries of the investment world has been why the dividend yield model stopped working about a decade ago. That model, based on stocks' dividend-to-price ratios, used to be one of the most respected valuation models on Wall Street. Not any more.

Today's investors, fixated on making a quick buck, are likely to wonder how anyone could ever have been interested in something so obviously irrelevant as dividends. But until the dividend-yield mystery is solved, I do not believe that the model should be dismissed so casually -- especially in light of its near-perfect previous record in forecasting severe market declines.

Before the 1990's, stocks invariably entered a major bear market when their average dividend yield dropped to 3 percent. But since the average yield fell to that level in 1991 -- it is now below 2 percent -- the stock market's value has more than tripled.

The prime suspect in the model's demise has been corporate share repurchase programs. Such plans were quite rare as recently as the early 1980's, but they have since grown so much that corporate America spends more of its earnings today on buying back shares than on paying dividends. Therefore, the argument goes, record low dividends simply reflect a shift in how corporations distribute their earnings -- hardly a bearish development.

But two finance professors, Eugene Fama of the University of Chicago and Ken French of the Massachusetts Institute of Technology, contend that this argument does not completely solve the mystery. According to their research, at least half the decline in the dividend yield over the last two decades has been caused by factors having nothing to do with that trend.

In particular, the professors point to the higher percentage of unprofitable companies -- the kind that have hardly ever paid dividends. Before 1980, rarely were more than 10 percent of companies unprofitable in any given year. In contrast, at the end of 1998, more than 30 percent of companies were unprofitable -- an increase that is difficult to interpret bullishly.

Is there any way to square these divergent explanations of the low dividend yield? I think that there is. But first, we shouldn't view the stock market as homogenous; instead, we should focus on the stark differences between companies that repurchase their shares and those that do not.

According to two other finance professors, Gustavo Grullon of Rice University and Roni Michaely of Cornell, about 90 percent of all share repurchases are by companies that also pay a dividend and are relatively large and profitable. The average market capitalization of companies that do both is more than 12 times greater than the average company that does neither. Moreover, the average company that engages in neither activity is unprofitable, while those that do both have an average annual return on assets of nearly 15 percent.

For the companies that do both, repurchases have undoubtedly lowered their dividend yields. To show this, Professors Grullon and Michaely applied a dividend forecasting formula retroactively to 1972 (it did not take repurchases into account). Although there were variations, the formula, on average, was accurate for companies that did not buy back their shares. But for companies that did, the formula called for dividends that, on average, were above the actual numbers. This suggests that for larger-cap, dividend-paying blue chips, a low dividend yield may not be bearish.

But be careful not to generalize this finding to the entire market. At the same time that blue-chip companies have been substituting repurchases for dividends, the number of unprofitable companies has grown markedly. That is an ominous development, and bullish investors are blinding themselves to it when they think that the mystery of today's low dividend yield can be explained solely by buybacks.